For bond markets, the start of 2017 felt like the dawn of a new economic era. The incoming US President, Donald Trump, was vowing to boost the US economy via ambitious infrastructure and tax reform programmes.
Yet Trump’s bold plans to reinvigorate the US economy progressed much more slowly than expected. No significant infrastructure developments have materialised in 2017. While tax reform may benefit some US corporations, it is unlikely to have a major macroeconomic impact.
The gradual normalisation of monetary policy, including through the slow withdrawal of quantitative easing, was a response to improving growth dynamics and signs of nascent inflation. But it failed to ignite a material repricing of bond yields.
No change ahead
Looking ahead to 2018, it is unlikely that US tax reform will substantially boost the country’s growth rate. That said, the wider macroeconomic backdrop remains favourable. The upturn that started before Trump’s election has continued this year. US and Europe are both growing at faster than their trend growth rates, although more slowly than in previous cycles.
There is already enough evidence that the US economy is recovering for the Federal Reserve to have started withdrawing monetary policy accommodation. The European Central Bank is likely to start along the same path in due course. It is fair to conclude that as we enter 2018, the peak of extraordinary monetary policy is behind us.
All these factors would normally suggest a bad environment for bonds. But yields are only a little higher than the extreme lows they reached in late 2016. They remain at very low levels by historical standards, and are much lower than one might expect at this point in the economic cycle.
The end of the cycle
While bond yields remain low, equity markets seem to hit new highs every week. Many indicators suggest that we are in a late cycle economic environment. Credit spreads are extremely tight, with corporate and consumer leverage at high levels. It seems unlikely that the current rates of economic expansion can be sustained over the next year.
Several factors contributed to 2017’s large increase in economic activity, but they are unlikely to be repeated in 2018. Much of the expansion over the last 18 months has resulted from a boom in US energy infrastructure investment as a result of the recovery in oil prices, which is unlikely to be repeated.
China’s credit splurge, as policymakers tried to revive the country’s property market, helped emerging markets and boosted global trade. With China increasingly concerned about its own financial imbalances, another spending spree in 2018 is unlikely.
Consumer confidence is high in the US, but while consumption is growing, real disposable incomes are increasing only very slowly. It is not clear that the US can continue to expand household credit sufficiently for the consumption boom to be sustained.
Global levels of leverage are very high and monetary policy stimulus is being withdrawn at a time when past drivers of growth are likely to fade. The degree of optimism and the level of valuations in risk markets are extremely high. There is a reasonable chance of a change in mood in 2018, which tempers our expectations for higher bond yields.
An artificial environment
A combination of unorthodox macroeconomic policy and structural trends continues to distort bond markets. An enormous amount of liquidity is still being injected into the financial system. While the world’s central bankers are at various stages in the process of withdrawing artificial stimulus, it continues to depress bond yields.
As we have learnt over the last few years, quantitative easing does not respect borders and liquidity provided in one country finds its way into others. While the scale of the distortion of bond markets by central banks is possibly less than it has been in previous years, it is still an ongoing factor.
Bond prices are being further bolstered by structural factors. Ageing populations need income, driving investors into bonds and suppressing yields. And since the global financial crisis, there has been sizeable, regulator-driven demand for safe assets. As regulators have cracked down, banks must hold a much larger proportion of their balance sheets in treasury bonds.
Finally, the neutral level of real rates in advanced economies has been declining for 30 years, thanks to demographic change and low productivity gains. While neutral rates could recover somewhat, there is nothing on the horizon, certainly over the next year, that is likely to meaningfully reverse that decline. All these factors limit the degree to which bond markets can sell off and yields can normalise.
Finding relative value
In an uncertain environment, investors should consider opportunities selectively and search for relative value. We identify the divergence in economic cycles from country to country. For example, the US cycle is further advanced than the European cycle, although Europe’s buoyant growth suggests that its monetary policy will now begin to normalise slowly. That, in turn, suggests that the current spread between German and US yields is too high.
In addition, there are selective opportunities in emerging markets. There is room for rates to decline in markets like Mexico and Russia, for example. We deploy FX strategies similarly to fixed income, looking for relative value. Without a strong directional theme, investors must focus much more on changing cross-market dynamics. It may also be possible to express views about the cycle through relative yields on short- and long-dated bonds.
We are less bullish on the US dollar next year than most of the market, as we believe that the locus of growth and of policy normalisation will begin to shift elsewhere. We continue to feel that the euro is under-owned, and that the Euro Area’s current account dynamics should provide support for the single currency.
The world economy has performed much better than we expected 12 months ago. However, risks to the status quo are finely balanced. With debt levels high, asset valuations rich and the cycle nearer to the end than the beginning, demand for safe-haven assets may be stickier than expected.
Adrian Hilton - Head of Global Rates & Currencies - Columbia Threadneedle Investments